The cyclical versus structural stock debate continues

There seems to be growing divergence among strategists about just how much corporate profitability can recover over the next few years, and therefore whether stocks look cheap or not.
Citi
’s
Tony Brennan
thinks that if returns on equity can get back to their average level of the past decade, price earnings multiples on associated earnings could still be “modest" for a number of cyclical stocks.

Of course, there’s still plenty of uncertainty as to how much weakness for industries is structural or cyclical. But an examination of some key indicators makes Tony think there’s probably a reasonable cyclical element. A while back, Citi has noted while P/E ratios had risen, forecast earnings were still weak for a lot of cyclical stocks. That, Tony says, implied low ROE for a number of years and also that earnings could recover more.

Citi’s spin is to not take higher P/Es as a sign stocks are fully valued, but rather that actual earnings are still weak, even the consensus forecasts. And they’re replacing a few industrial names in their recommended portfolio. “Even with P/Es a little higher in the last couple of months, the potential still offered by some of the cyclical stocks is in the scope for their earnings to recover more than is forecast, something that shouldn’t be out of the question given the low ROEs still projected."

So it’s down to companies’ potential to revert to mid-cycle earnings levels, rather than consensus. It shouldn’t be implausible, Tony says, for companies to get back to the ROEs of the past decade, because that period has seen both buoyant and subdued times almost in equal measure on either side of the financial crisis.

Significant change in revenue growth

However, it doesn’t resolve how much weakness now is attributable to cyclical conditions and how much would be due to structural issues that could hold ROEs low for some time to come. What stands out from Citi’s analysis is the significant change in revenue growth before and after the financial crisis, and the impact this has had on operating margins.

A main take-away is that the decline in ROEs appears to have come courtesy of a deterioration in operating performance rather than deleveraging. So improved operational performance should provide scope for higher ROEs again.

Looking at individual sectors, some, like building construction, look more like they’re suffering from cyclical weakness, whereas others, like advertising spending, consumer spending and sharemarket turnover, are facing structural pressures.

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That makes it tough to believe in “mean reversion". More than half the cyclical stocks Citi looked at have been achieving ROEs about 10 per cent or more lower than pre-GFC, which means they’re either just meeting or falling short of their cost of equity. “In theory, this shouldn’t persist: either both revenue and margins pick up, or capacity and capital should leave the industry. In some industries some capacity has been shut down in recent years, but some revenue and margin improvement is also anticipated. It’s just difficult to assess the extent with the structural pressures."

Tony’s view is that even in the structurally affected sectors, there’s still likely to be a reasonable cyclical pick-up over the next few years, and so cyclical industrials aren’t looking as fully valued.

The broker has added a handful of cyclical names to its “recommended" portfolio.
BlueScope Steel
,
Fletcher Building
,
Harvey Norman
and
Macquarie Group
now take the place of
Orica
,
Crown
,
Myer
and
AMP
.